A Quick Overview of What Principal and Interest Means
I’m going to get technical and explain what ‘Principal & Interest’ means, particularly for those of you who with a stack in offset are wondering why your repayments are so big.
Firstly, you’ll cop a higher interest rate if you choose your loan to be set as “Interest Only” which means you’ll pay more interest for such simplicity. But let’s start with that.
As you know, banks charge interest on a daily basis, calculated on the loan balance less what you have in offset. So, if you have an interest only investment loan of $900,000 loan with $300,000 in offset, the bank will charge you interest on the ‘effective’ debt of $600,000 (what you’ve actually used).
If the rate is 2.59%PA, the interest charged will be around $15,540 every year (being $900,000 less the $300,000 in offset).
It’s calculated as $300,000 x 2.59% = $15,540. That’s $1,295 per month.
That’s easy to calculate, but how about if your loan is structured as P&I?
It can be tough to understand that even when you have a stack in offset, every month the bank will still take from your offset account the contracted P&I repayment, which on $900,000 is $3,598. This payment will not change whether you have anything in offset or not.
Please remember that the interest component of a P&I repayment is still (as always) calculated on a daily basis, calculated on the loan balance less what you have in offset. It's exactly as it was before, being $1,295 per month.
Having all those funds in offset means the interest component of the P&I repayments is much tinier than if there was nothing in offset. Of the contracted monthly payment of $3,598 if only $1,295 is interest, the principal reduction portion of the contracted P&I repayment will be $2,303.
So after the first payment is made after the first month of the loan, the balance of the loan will reduce from $900,000 by $2,303. You see, because of the funds in offset, your 30-year loan will be paid out in much less than 30 years.
I know this is a bit confusing but it’s important that you understand that interest is only actually charged on your effective debt (the bit you have used) and that the extra principal reduction being made is being funded by your stack of cash on offset (it’s not really coming from your pocket).
To make things simpler, we may suggest in the above instance to have the loan facility being divided into 2 splits, of $600K and $300K.
For Loan A, the $600K would represent what you actually owe, and with little in the offset account, the contracted P&I repayment would slowly repay the loan on a P&I basis over 30 years.
For Loan B, the $300K loan (let’s call it your equity loan) would be completely offset by the $300,000 sitting its own non-transactional ‘equity offset’ account. The interest component of the $1,199 contracted repayment is nil, so the loan and the offset account would decrease every month by $1,199. The offset balance and the loan will always be the same and diminish over time.
No matter what kind of loan you're going to get, getting good pieces of advice from a reliable mortgage broker Sydney has to offer can make your loan experience better.